A Five-Step Financial Checkup

A five-step financial checkup

Many of us diligently go to our doctor for an annual physical. We need a regular health checkup not because we are sick, but to help us stay well. Checkups help us keep track of some key health indicators: cholesterol level, heart rate, blood pressure and others. Knowing these numbers, and noting any change over time, is reassuring when our numbers are good. When they are less than ideal, they let us know it’s time to improve our diet or exercise program.

Our financial health ought to be checked regularly, too. Instead of going to a doctor, we can do our own annual financial health checkup. In just five steps we can measure and monitor our financial health using key indicators like our net worth, debt ratios, credit score, savings need and emergency fund. By being aware of these numbers and making any necessary changes, we can identify areas for improvement.

Step 1: Determine your net worth

Figuring your net worth may be the simplest, yet most important financial checkup step. Your net worth statement, or balance sheet, is a snapshot of your current wealth. It compares your assets—what you own, with your liabilities—what you owe. The difference is your net worth.

To start, list the value of your financial assets such as bank balances, retirement funds and investments. For non-financial assets such as cars, a house and personal property, list the amounts you could reasonably expect to get if you sold them today.

Liabilities include current outstanding bills, mortgage balances and other loan and credit account totals. By subtracting total liabilities from total assets, you will find your current net worth.

There is no “correct” net worth figure. Your personal target depends on your goals, earned benefits, and assets.

There are two ways to increase your net worth: 1) increase your assets by saving and investing and 2) decrease your liabilities by reducing debt. (See the “Net Worth” article in this issue)

Step 2: Calculate your debt ratios

Knowing your debt ratios helps you avoid the trap of owing more than you can comfortably pay.

Three debt ratios are commonly used by lenders to test your credit worthiness before making you a loan: the debt to income ratio, the front ratio and the back ratio. To calculate these ratios you need to know your monthly pre-tax income, monthly debt payments and housing costs. Your housing costs are the total of your monthly mortgage, property tax, homeowners insurance, utilities and any condo fees or homeowners association dues. Your monthly debt payments are all other credit payments (e.g., student loans, credit cards, car loans).

The debt ratio considered to be the most important by many lenders is your debt to income ratio (DTI). Your DTI is found by dividing your monthly debt payments by monthly pre-tax income. So, with a gross monthly income of $3,000 and monthly debt payments of $300, the debt to income ratio is 10 percent ($300/$3000 = 10%). Many financial planners see a debt to income ratio of less than 10 percent as credit worthy; a ratio above 20 percent signals caution.

Another key debt ratio, often used by mortgage lenders, is your front ratio. This is the percentage of your monthly pre-tax income needed for your house payment. A $3,000 monthly gross income and $750 housing costs is a 25 percent front ratio ($750/$3,000 = 25%). Traditionally, mortgage lenders say that your front ratio should be 28 percent or less. Your back ratio is the total of your housing costs and monthly debt payments divided by your pre-tax income. A $3,000 monthly gross and total debt payments of $1,020 is a back ratio of 34 percent ($1,020/$3,000 = 34%). Lenders typically use a back ratio of 36 percent as the highest to qualify for standard loans.

Unfortunately, many lenders have become tolerant of high debt ratios. Some lenders extend credit to families with debt ratios that exceed proven standards. Trusting that lenders will enforce lending standards to protect them, some families are surprised to find themselves in financial difficulties after getting a loan. With lending standards so relaxed and loans easier to obtain, personal bankruptcies and other signs of financial distress have increased.

Given today’s lenient lending standards, knowing and understanding your own debt ratios will help you protect your credit and increase your ability to make debt payments.

Step 3: know your credit report and score

Your credit score is a three-digit number that lenders use to determine if they will lend you money, and at what rates. It is based on your credit history as recorded by the three major credit bureaus: Experian, Trans Union and Equifax.

A new federal law requires each credit bureau to give you a free copy of your credit report once each year. You may request a copy of your report online at www.annualcreditreport.com, or by calling toll free at 1-877-322-8228.

Once you obtain the report, closely read the information provided. Don’t ignore errors. If errors are found, immediately start the process to correct them to assure complete accuracy and to identify any unauthorized use of your credit. The earlier you detect any misuse, the sooner you will be able to make corrections.

After seeing that your credit information is accurate, it’s a good idea to check your credit score. Each bureau sells a score based on their own information, but the one most often used by lenders is from Fair Isaac Corporation (FICO) and can be ordered at www.myfico.com.

Your FICO score is a key financial number worth understanding. A poor score is costly when you borrow, and can result in denial of credit. FICO scores range from 300 to 850 with lenders often using a score of 720 as the minimum for the best credit terms. Some lenders may even increase the rate on a loan or credit card after a score drops below some level. For a margin of safety, it is best to keep your score well above 720 by always paying bills on time, maintaining favorable debt ratios and following the hints published at the Fair Isaac Web site.

Step 4: Calculate your savings need

Another key number to help monitor your financial health is the difference between savings needed to meet your long-term goals, such as retirement, and your actual savings amount. The savings requirement numbers you calculate can be compared to the amounts you are already saving to see if you are saving enough annually to meet your retirement goals.

The most common long-term goal is retirement. You can use ICMA-RC’s free online calculator at www.icmarc.org/xp/rc/planning/tools/retirement.html to see if you are on track. By using your current information and making thoughtful assumptions about your situation, you can calculate whether you are on track.

Of course you may have other financial goals as well. Perhaps you want to pay down debt, help your children with college expenses or put aside a down payment for a house. You can calculate savings needed for these goals, too, by using ICMA-RC’s free online calculators.

Step 5: Know your capacity to manage financial emergencies

Sound financial planning includes an emergency fund. It’s a good idea to keep easily accessible funds equal to at least three to six months of your living expenses in case of emergencies. For example, you could need cash to pay out-of-pocket deductible costs to repair your car after an accident, to meet bills between jobs after a layoff, or, for uninsured health care expenses.

Families with an inadequate emergency fund can find themselves in a bad situation when they are forced to borrow money at just the wrong time. Untimely borrowing can turn a modest size emergency into a life changing event, because it usually means high interest rates and digging into your savings. Emergency debt can undermine your long-term financial goals.

To find the minimum amount of emergency funding you should have, estimate the amount you need to live on monthly and multiply by three. As your expenses increase over time, so should your emergency fund.

Your emergency fund ought to be held in a liquid, safe account such as a bank savings account, money market account, certificate of deposit, or money market fund.

Conclusion

As with any good exercise program, starting sooner will help you realize your goals for improving your financial outlook.